14.54 F16 Lecture Slides: 'Standard' Trade Model (II ... · 14.54 International Trade Lecture 7:...

14.54 International TradeLecture 7: ”Standard” Trade Model (II)

Changes in Terms of Trade

14.54

Week 4

Fall 2016

14.54 (Week 4) Changes in Terms of Trade Fall 2016 1 / 43

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Today’s Plan

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Changes in Terms of Trade: Small Open Economy Terms of Trade and Welfare Changes in Terms of Trade: World Economy Trade Protection and the Terms of Trade

The small graphs on slides 5-9, 11, 12, 14, 25, 27-29, 31-34,36, 39-41 were created by Marc Melitz. Used with permission.

14.54 (Week 4) Changes in Terms of Trade

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1. Changes in Terms of Trade: Small Open Economy


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Changes in Terms of Trade

A country is open to trade at world trade price pT

So, this country can be affected by changes in the rest of the world In a competitive model, those changes are transmitted only through their effect on pT (and hence the country’s terms of trade)

How do changes in the terms of trade, pT , affect a country? For expositional clarity, we will assume that this country exports C so that an increase in pT represents a terms of trade increase We will start by looking at this impact in the short run, when production Q does not respond ... and then look at the long run impact when Q responds to the change in pT


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Recall the Open Economy Equilibrium


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Changes in the Terms of Trade in the Short Run

TProduction remains fixed at QT : What happens as p changes? Assume that changes in pT are not so extreme that this country no longer exports C

An increase in pT shifts out the relevant portion of the budget constraint (and conversely for a decrease in pT ) T T p /: positive income effect. p �: negative income effect


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Income and Substitution Effects of Price Changes

TCase 1: p /

Substitution effect: D1 −→ DB Income effect: DB → D2

How do DC and DF respond to an increase in pT ? DF must increase (reinforcing income and substitution effects) Change in DC is ambiguous (opposite income and substitution effects)


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Income and Substitution Effects of Price Changes

TCase 2: p

DB → D2Substitution effect: D1 −→ DB Income effect:

How do DC and DF respond to a decrease in pT ? DF must decrease (reenforcing income and substitution effects) Change in DC is ambiguous (opposite income and substitution effects)


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What if a Country Exports F when Trade Price Decreases

Substitution effect of demand must go in same direction but income effect is reversed

DC must increase (reinforcing income and substitution effects) Change in DF is ambiguous (opposite income and substitution effects)


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Income and Substitution Effects: Summary

Substitution effect: T Tp / then DC and DF / (and conversely when p )

Income effect: Depends on good that is exported If relative price of export good rises (terms of trade improvement)

Then DC and DF both increase (positive income effect)

If relative price of import good rises (terms of trade deterioration) Then DC and DF both decrease (negative income effect)


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Long Run Effects of Increase in Terms of Trade

No change in substitution effect Positive income effect is reinforced by response in production


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Long Run Effects of Decrease in Terms of Trade

No change in substitution effect Negative income effect is lessened by response in production Note that overall welfare effect is still negative

Welfare effect of production response can never overturn direction of income effect (unless pattern of trade is reversed)


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2. Terms of Trade and Welfare


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Terms of Trade and Welfare

A decrease in the terms of trade will induce a welfare loss until theautarky point is reached

Very large changes in pT can reverse the pattern of trade (and hence the direction of the income effect)Empirically, this type of change can only occur over a span of manyyears


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Quantitative Effect of Terms of Trade Changes on Welfare

Empirically, how large are the welfare effects driven by changes in terms of trade? How much have developed countries been hurt by increased trade with developing countries?

Fear: as developing countries industrialize, world supply of manufactured goods exported by developed countries increases and drives down the relative price of those goods

Question 1: Empirically, how big are changes in the terms of trade?


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Changes in the Terms of Trade for Developed Economies


Table 5-1 from International Economics removed due to copyright restrictions.

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Changes in the Terms of Trade for Primary Products

Figure 2-12 from International Macroeconomics removed due to copyright restrictions.


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Take Chile (in 2013)

Courtesy of AJG Simoes, CA Hidalgo. The Economic Complexity Observatory: An AnalyticalTool for Understanding the Dynamics of Economic Development. Workshops at theTwenty-Fifth AAAI Conference on Artificial Intelligence. (2011) Used with permission.


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Changes in the World Price of Coffee

Graph from International Trade removed due to copyright restrictions.


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Who Are the Big Coffee Exporters?

Courtesy of AJG Simoes, CA Hidalgo. The Economic Complexity Observatory: An AnalyticalTool for Understanding the Dynamics of Economic Development. Workshops at theTwenty-Fifth AAAI Conference on Artificial Intelligence. (2011) Used with permission.


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Quantitative Effect of Terms of Trade Changes on Welfare

Question 1: Empirically, how big are changes in the terms of trade?Question 2: Quantitatively, how to changes in terms of tradetranslate into changes in welfare?

Mathematical postscript to textbook shows how to derive changes inwelfare (measured in terms of ‘real’ income) as a function of changesin the terms of trade:

TΔWelfare ($) = Value of Trade ($) × %Δp Welfare Trade T⇔ Δ = × %ΔpGDP GDP

Note: Value of trade is value of balanced exports or imports (not the sum)


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Quantitative Effect of Terms of Trade Changes on Welfare(cont.)

Recall:Welfare Trade TΔ = × %ΔpGDP GDP

Note: Value of trade is value of balanced exports or imports (not the sum)

Developed countries:Trade is 20% of GDP (on average, lower for U.S.) and changes interms of trade are less than 1% per year−→ Welfare effect of TOT: 20% × 1% = .2% GDP (max)

Developing countries (big exporters of primary products)Trade can be 20-50% of GDP and changes in terms of trade can be10-25% per year−→ Welfare effect of TOT: 2%-12.5% of GDPNonetheless, recall that TOT shocks can never reduce welfare belowautarky levels


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How Do Exports and Imports Respond to Changes in Trade Price?

Assume that a country exports C and pT increases (TOT increase) Demand: DF / and DC or / (if income effect dominates) Production: QC / and QF (movement along PPF)

Implications for trade: DF / and QF so IMF = DF − QF /DC / and QC /

Change in EXC = QC − DC is ambiguous, tough EXC / is the typical case

Summary: Import demand curves are always downward sloping Export supply curves are typically upward sloping but can be backward bending when the income effect from a price change is very large (dominates both the substitution effect in consumption and the production response)


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3. Changes in Terms of Trade: World Economy


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What Drives Changes in World Prices?

Changes within a country can only affect world prices when thatcountry is a large exporter or importer of a good (relative to the restof the world)If a country is relatively small, then changes in that country will notaffect world prices

Small open economy: affected by changes in pT but no feedback effect to pT

T In general, equilibrium p is affected by changes in RDW or RSW


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Changes in World Relative Demand

Driven by changes in consumer tastes or by changes in income per capita (if preferences are not homothetic) If changes are driven by increases in income per capita, then this will tend to benefit the terms of trade for developed countries (and hurt the terms of trade for the poorest countries) Empirically, the evidence for such terms of trade changes are limited Especially relative to the large effects of changes in world relative supply

These changes are quantitatively much larger than shifts in demand


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Changes in World Relative Supply

Example 1: Imperfect competition

OPEC cartel increases world price of oil by reducing world supply


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Changes in World Relative Supply (Cont.)

New countries ‘open up’ to international trade

Recall that this country must be large relative to the rest of the world


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Changes in World Relative Supply: Country Growth

Assume that foreign is growing First assume that growth is unbiased so RS∗ is unaffected by growth:

Unbiased growth will decrease foreign’s terms of trade and increase home’s terms of trade


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Changes in World Relative Supply: Country Growth(Cont.)

What if growth is biased?If growth is biased towards the export good, then terms of tradeeffects are reinforcedIf growth is biased towards the import good, then the bias of growthworks against the terms of trade effect

The bias could be so extreme that the terms of trade of the growingcountry improve


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Welfare Effects of Growth on Growing Country

Two effects: Positive direct effect of growth (shift out of PPF) Secondary effect through changes in terms of trade (if country is large)

If a country is closed to trade, then only positive direct effect is present:

This effect is irrespective of any bias of growth


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Welfare Effects of Growth on Growing Country: SmallOpen Economy

Similarly, a growing small open economy will also only experience thepositive direct effect from growth

Note that the budget set for the aggregate consumer must shift out

Again, this effect is irrespective of any bias of growth


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Welfare Effects of Growth on Growing Country: Large Open Economy

Growth will now affect terms of trade:

If growth induces large decrease in terms of trade, it is then possible (but not likely) that the negative welfare effect from the terms of trade decrease dominates the positive direct effect from growth

This is called immiserizing growth


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Immiserizing Growth

This is an extreme case, but is nevertheless possible for very large exporters of primary goods When is immiserizing growth more likely to occur?

When growth is biased towards the export good When relative demand is very inelastic (very little substitution between export good and other goods)

Then changes in export supply can have large effects on relative prices


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Back to Coffee

Courtesy of Macmillan Higher Education. Used with permission.


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4. Trade Protection and the Terms of Trade


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Import Restrictions and Subsidies

An import restriction (import tariff or other barrier) or export subsidy induces different prices inside the country relative to the world trade prices

Both the import tariff and the export subsidy will raise the internal price of a good:

An import tariff on C (for a C importer) or an export subsidy on C (for Ta C exporter) raises pC /pF inside the country relative to p

Note the difference between an export subsidy and a production subsidy (which would lower the relative price of a good)

If a country is small relative to the world, then this trade restriction Twill not induce any changes in RDW or RSW and hence in p

So only internal relative prices change


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Import Barrier in a Small Open Economy

Consider a small importer of F considering an import tariff on F... which would lower pC /pF inside the country but would not affect Tp

... and shift demand from F to C and supply from C to F inside thecountry

Such a restriction must generate welfare lossesSimilarly, an export subsidy will also generate welfare losses


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Import Barrier in a Large Economy

Now consider a large importer of F considering an import tariff on FTThis will lower pC /pF inside the country and also will affect p

The lower internal pC /pF will shift demand from F to C and supply from C to F inside the countrySince this country is large, this will also affect RDW and RSW

This generates a terms of trade improvement for the country


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Import Barrier in a Large Economy: Welfare Effects

The inefficiency from the distortion of the internal relative price stillinduces a negative welfare effectBut this effect must now be weighed against the positive terms oftrade effect

For a ‘small’ tariff, the positive welfare effect from the terms of tradewill dominate and welfare will rise but the effect is reversed for a‘large’ tariff


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Optimal Tariff for a Large Economy

Welfare is maximized for a large economy by setting a small import tariff However, this welfare gain comes at the expense of all the other countries in the world ... and reduces world welfare Retaliation by other large countries would then make all countries worse off


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Export Subsidies

For a large economy, export subsidies are even more detrimental towelfare than for the small economy

Because the export subsidy generates a decrease in the large country’sterms of tradeAn export subsidy on C by a large C exporter will shift in RDW and shift out RSW


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